Business owners want clarity about their company’s financial health, and a financially healthy business means growth. A major player in business growth is free cash flow, but understanding what this is and how to calculate it can be tricky.
Understanding free cash flow helps business owners plan for future growth and if the company is incorporated, plan for investments that would improve shareholder value. Free cash flow can be used in a business plan as part of financial planning and forecasting.
What is free cash flow?
Free cash flow (FCF) is a measurement of a business’s financial health and performance. It is all the financial assets left after deduction of operating costs (wages, supplies, overhead) and purchasing assets (equipment, property, other major investments).
Free cash flow is a measurement of available cash that can be distributed among investors or used for other business growth purposes. A healthy level of free cash flow is the ideal position that every entrepreneur wants to be in.
How to calculate free cash flow
There are a few ways to calculate free cash flow, but for the most part, it’s fairly simple. The most commonly used formula is:
Free cash flow = operating cash flow (OCF) – capital expenditures
While the formula may be simple, understanding a business’s operating cash flow and capital expenditures takes strong accounting skills and one of the major reasons why keeping accurate financial statements and accounting is so important for a business.
Using operating cash flow
Operating cash flow is cash flow from the operations of a business for its regular business activities such as sales and services. It is the first assessment calculated on a business’s cash flow statement.
While cash flow statements (also known as a statement of cash) aren’t used by every business, they are an essential part of accounting for companies that use the accrual accounting method. A cash flow statement provides information on the amount of revenue a business has generated but may not have received yet.
An operating cash flow statement is broken down into three components:
Operating activities:
This is the day-to-day operating earnings of a business. This includes revenue pending from outstanding customers and where those funds will be allocated.
Investment activities:
This is cash flow from investments and how much profit a business is earning from those investments.
Financing activities:
The financing activities are a record of the sources of cash accrued from investors and banks. This is similar to a balance statement’s liabilities, including outstanding debts and loans.
Using sales revenue
Sales revenue is just what it sounds like: revenue garnered from sales of goods and services. The terms “sales” and “revenue” are often used interchangeably, but revenue doesn’t necessarily mean cash on hand. Sales are all the earnings from sales of products and services only, revenue is all the money a business receives from all sources.
Sales revenue can be listed on an income statement as either gross (total revenue before any debt or operating expenses deductions) or net (all debts and operating expenses deducted).
Sales revenue is a valuable metric for financial reporting and forecasting, which is why it is always listed at the top of an income statement. Think of it as the reference point for all other calculations and analyses on the income statement.
Calculating sales revenue is a three-step process:
1. Determine the unit price
Determine the price of each unit, product, or service you will be selling. For example, if you are selling print-on-demand t-shirts at a price point of $20 each, that will be your unit price. Most businesses, however, sell a much wider range of products and services, so this step will need to be completed for each and every product and service that the business sells.
2. Calculate the total units sold
After unit pricing, this is fairly self-explanatory and requires taking inventory of all stock sold and still remaining on-hand. With these figures, you can calculate the amount of sales revenue generated from operating activities.
3. Units multiplied by the price
Now that you have the individual unit price and the amount of each unit sold, you can simply multiply them together to get the total amount of sales revenue generated. Let’s take the print-on-demand t-shirt example.
Let’s assume you have two different types of t-shirts for sale: long-sleeve and short-sleeve. The long-sleeve shirts are $30 and the short-sleeve shirts are $20. You sold 1,000 of the long-sleeve shirts and 750 of the short-sleeve shirts. Now do the math:
Long-sleeve shirts: 1,000 x $30 = $30,000.00
Short-sleeve shirts: 750 x $20 = $15,000.00
Total sales revenue: $45,000.00
Using net operating profits
Net operating profits are a business’s earnings after all expenses are deducted except for debts, taxes, and a few other exceptions. Net operating profits aren’t to be confused with net operating income, which is the profit remaining after all expenses have been deducted from revenue of sales.
Net operating profit is the amount of revenue that remains after deducting all the variable and fixed operating costs. Basically, it shows the profit a business is earning and is an invaluable metric on your financial statements.
Net operating profit can be calculated using the following formula:
Net operating profit = operating revenue – cost of goods sold – depreciation and amortization
While the formula looks simple, determining figures such as depreciation and amortization takes some skill and is one of the reasons why many business owners outsource professional accountants to undertake this task for them.
What is the ideal free cash flow (FCF)?
Just like everything with business, there is an ideal balance between cash flow and reinvestment. For investors, creditors, and analysts, an ideal cash flow is imperative. Overall, businesses that are trending high on cash flow ratio are looked upon favourably as in good financial health.
But what is a cash flow ratio? The operating cash flow ratio, also called a liquidity ratio, can be calculated as follows:
Operating cash flow ratio = Cash flow from operations / current liabilities
Cash flow from operations can be found on a business’s income statement of cash flow. Current liabilities are all obligations such as debt, accounts payable, and liabilities that are due within the fiscal year.
An ideal cash flow ratio is greater than 1.0.
Free cash flow benefits
Regardless of how passionate an entrepreneur is about their business, at the end of the day, they need to make money and free cash flow is optimum. Free cash flow allows businesses to pursue growth opportunities such as investments, purchases, or the development of new products and services. Without free cash flow, businesses aren’t able to do this and can stagnate or worse, not be able to pay down debt.
Free cash flow is also leverage if a company is looking for investments to expand. Without being able to demonstrate financial health via free cash flow, investors won’t be keen to invest in that company.
Free cash flow limitations
While free cash flow is a major goal for all companies, there are limitations.
1. No forecast is a crystal ball
Financial forecasts are simply well-educated guesses or assumptions. While they can be relied upon, there are always factors out of everyone’s control that could impede a company’s free cash flow. There is always room for error and some investments can backfire.
2. Free cash flow is best for short-term only
Free cash flow is great for short-term projections and investments, but over the long run, there are too many variables. Recessions, advancements in technology, or bad reviews on a brand new product, can steer a company in a direction that could never have been anticipated.
3. It only works with complete transparency
This may seem like a no-brainer, but free cash flow is only beneficial if all financial statements are comprehensive and completely transparent. There can’t be anything left off the books or calculated incorrectly. Otherwise the final free cash flow calculations will be incorrect and that can land a lot of people in hot water. This is also applicable when filing tax returns and accounting for free cash flow.
What does free cash flow tell you?
Free cash flow measurements take the guesswork out of a lot of valuations. Free cash flow measurement is something like a business’s health check-up and it can tell you how well your business is doing. It can tell you if you need to adjust your unit prices, if you are able to invest in the coming year, or if this is the year to start developing that new product.
Free cash flow can also give you insight into how valuable your company is to investors, which can help with future planning. Free cash flow allows investors to have an intrinsic stock value.
Having a healthy free cash flow is a business milestone. Entrepreneurs want to make money and continue growing their businesses, and knowing the value of free cash flow can help with that.
This article offers general information only, is current as of the date of publication, and is not intended as legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. While the information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by RBC Ventures Inc. or its affiliates.